The new emerging markets? - Angles & Perspectives Q3 2022

The new emerging markets?

Many developed markets have followed aggressive policy choices more reminiscent of those of emerging markets (EMs) of 20 years ago. The combination of very loose monetary policy and high debt burdens was joined by massive fiscal stimulus and wide deficits in response to the Covid-19 pandemic. Given this, it is no surprise that economic and, more recently, market outcomes have become very volatile. Investors need to be careful of backward-looking risk measures in this environment of long-cycle inflection, and avoid ‘long duration’ assets.

Investing in EMs has needed a strong stomach
EMs’ economic track record is punctuated by regular financial crises. More standout episodes include Latin America in the early 1980s, the Southeast Asian ‘Tigers’ in 1997/8 and the Russia/LTCM crisis in 1998. The past decade or so has seen severe underperformance from EMs generally. Key pressure points included Argentina defaulting on debt (2014 and again in 2020) and more recently, in 2022, Turkey, Pakistan and Sri Lanka being severely impacted by the combined impact of collapsing currencies and high energy and food prices.

Residents and investors in the likes of South Africa, Brazil and Turkey have learnt to weather high currency, interest rate and equity market volatility. While the root cause of this has been ascribed to messy politics and poor economic policies, in practice, very pro-cyclical foreign capital flows are also responsible for exacerbating price moves. The Russian invasion of Ukraine and growing concerns about the investability of China have recently impacted sentiment. Most importantly, the long period of EM underperformance over the past decade has seen substantial capital outflows, resulting in further reflexive price weakness. Currently, EMs can only be described as ‘very out of favour’.

The new emerging markets
If we asked you which countries have been running large twin deficits (budget deficit and current account deficit), are behind the curve in monetary policy with negative real rates, and are battling to control inflation, people typically say it must be an emerging market, like South Africa or Brazil. Well, you would be wrong. Over the past two years, South Africa and Brazil’s twin deficits have averaged 4.3% and 9.7% respectively. This compares to 12.5% for the UK and 15.4% for the US. It is clear that since the Covid-19 pandemic, developed market policymakers have overcome their historic reluctance towards fiscal stimulus and will use it repeatedly in the future in response to any ‘crisis’ – take, for example, the huge spending programmes in Europe (EUR376 billion) and the UK (GBP130 billion) to alleviate the current spike in energy prices.

Inflation rates are currently higher in the UK, US and Germany than in SA and Brazil, a historically rare occurrence. The German consumer price index (CPI) just hit 10%, way above the 1974 peak of 7.9%. The German producer price index (PPI) is over 45%, the highest level since 1948!

As for monetary policy, much has been made of recent rate increases, but that needs to be seen in context of the zero and negative policy rates in place until very recently. Brazil has completely normalised monetary policy post Covid-19, and South Africa is also a hike or two away from restoring a normal rate environment. In contrast, developed market central banks are still way behind the curve in their fight against inflation. This is highlighted by current real policy rates, still ranging from -5% to -10% in the US, UK and Germany.

Vincent Deluard, a macro strategist with StoneX, had this to say in a recent podcast:
“The market denies the reality because we think of inflation as an emerging market problem – something for Brazil and Turkey. In the West, we’re smarter than that, we’ve read Paul Samuelson, it doesn’t happen here.

“But look at what policymakers have done: Deny inflation, lie about it, blame it on Putin, call it transitory, refuse to hike, hike but below inflation, send stimulus cheques, seize oil company profits.

“This is the Erdogan playbook. If developed countries start acting like emerging countries, shouldn’t we expect an emerging market outcome for them?” - Vincent Deluard, 1 July 2022

While this past year has been characterised by US dollar strength, it is interesting how other currencies have performed. The market appears to be gradually acknowledging that the countries running the risky policies described above are no longer just to be found in the EM bucket. For example, the dramatic depreciation of the UK pound and the Japanese yen typify an 'EM outcome'.

The start of the Great Rotation?
Late last year, we highlighted that the Covid-19 pandemic appeared to mark some important cycle turning points, with the new environment characterised by sustained higher inflation and strong nominal growth. After a decade of underinvestment and neglect, the EMs and ‘old economy’ sectors such as energy and mining are likely beneficiaries of this new environment.

Since then, there have been some dramatic declines in prices. While we all know the tech sector can suffer steep declines, developed market government bonds have historically been held as risk mitigators. To have declines of 31% (German bunds) and 43% (UK gilts) in under a year, is unprecedented.

What is really risky?
Wild fluctuations in currencies and bond yields happen on a regular basis in EMs, and hardly come as a surprise. Also, EMs are out of favour, under-owned and cheap by any measure, so there are few systemic consequences to this. That is not the case with many DM assets – for example, the massive holdings of government bonds at yields that still imply inflation will quickly fall and remain below target levels for the foreseeable future. The dramatic collapse in DM bonds has systemic implications, most recently seen in UK defined benefit pensions.

The use of quantitative measures derived from historical price volatility as a proxy for risk is nearly universal in modern finance. These models typically have look-back periods of 8 to 10 years, in essence calibrating risk on the long period of secular stagnation post the Global Financial Crisis (GFC). The huge exposure to expensive long duration assets is often justified based on these models. We believe that true risk for investors comes from a permanent loss of capital and, on the other end of the spectrum, the inability to deliver target returns over the long term.

“You point to problem children in EMs but it’s the developed world that has turned out to have Peronist monetary and fiscal policy, deeply negative real rates, twin deficits, printing and spending…Any seasoned EM investor knows what happens next when a country runs a twin deficit with an overvalued currency, an overheating economy and inflation surge, and deeply negative real rates.” - Whitney Baker, Totem Macro

In conclusion
When viewed through that lens, expensive, over-owned long duration assets with rapidly deteriorating economic fundamentals are the epitome of risk, irrespective of their price volatility in the decade after the GFC. In contrast, cheap, under-owned old economy and EM assets, well suited to today’s economic fundamentals, are attractive holdings with low ‘true risk’, despite higher historic price volatility.

PSG Asset Management.